THE STATE OF UKRAINIAN INDEPENDENCE: An overview from Harvard: Economic development (08/25/96)

THE STATE OF UKRAINIAN INDEPENDENCE: An overview from Harvard

Economic development

A roundtable discussion on the economic development of post-independence Ukraine was held on July 31 at Harvard University. Participants included Jeffrey Sachs, Galen L. Stone Professor of International Trade and Director of the Harvard Institute for International Development; Daniel Kaufmann of the World Bank (most recently chief of mission in Ukraine), currently a visiting scholar at the HIID; and Alexander Pivovarsky, coordinator for Ukraine at the HIID. Questions were posed by Lubomyr Hajda, associate director of the Ukrainian Research Institute; and Robert De Lossa, director of publications at the URI. Following are abridged excerpts from that discussion.

Q: On Ukraine's strengths and weaknesses over the past five years:

A: Jeffrey Sachs: Ukraine's present strength is that it has the potential to become a full-fledged European economy and the prosperity that would entail. We know from the economic history of Europe that when poor economies in Europe integrate themselves with their rich, powerful market-oriented counterparts, the poorer countries experience significant gains in living standards through the development of modern industry, modern services, improvements in agriculture, etc.

The big hope of independence was that the disasters of the Communist period and the relative affluence of the Ukrainian economy in history could be overcome by becoming a modern market economy very much integrated with the rest of the European system. That still is the hope. Ukraine has great human talents, wonderful agricultural potential and industrial potential. Almost all of this is unmet so far, because of a quite disastrous economic history. Yet we are only at the beginning of the period of trying to bring potential and reality closer together.

Daniel Kaufmann: Human capital needs to be emphasized, because in a country like Ukraine, one is starting from a much more sophisticated basis. But it is important to stress that if a country rests on its laurels (or "sits on its assets," whether education or land), then such potential can become a curse in disguise, instead of a blessing. In a sense, that is what happened in the first few years after independence.

Only since the new administration came into power in late 1994 has seriousness and purpose and leadership of economic reform begun. They recognized that human capital, the land and some of the other factors just mentioned can provide the basis for integration with Europe, for improvement in the future. But it entails enormously difficult challenges and real reforms. And in the case of skills it must be recognized that many of the skills have not been very well matched to a market economy. That requires new educational challenges, such as programs of public economic education and retraining.

Alexander Pivovarsky: When Ukraine was approaching independence, many newspapers and observers looked at the statistical data about Ukraine's production and said "Look, Ukraine is producing more steel than any country in the world" and they would elaborate such statistical figures without thinking that it actually is not an advantage for the country in some situations because the world steel markets could not absorb the production and because energy would have to be sold at the world price level. We would have to shift our economy from military to civilian production.

Q: On Ukraine's performance over the past five years:

A: Sachs: I had the opportunity to meet with President Kravchuk in December 1991. There were high expectations that independence alone would somehow lead to prosperity. Unfortunately, neither the president nor his economic advisers nor much of the leadership in Parliament recognized that independence alone was not going to provide the lift - it was only going to provide the opportunity to make major changes in economic policy to make possible future growth. For Ukraine there were profound challenges to get the basic functions of the state operating, to introduce basic institutions such as a National Bank and even basic industries, to become able to police the borders, create a basic law, etc.

Many important steps were taken, but on the economic front there was no clear direction for two or three years. There were calls by reformers for needed steps in making a market economy. There was lots of confusion. Many believed that no basic changes had to be made, that there was still time to improve what was essentially the old socialist process, that privatization of land and industry was not needed, for example. In the end this added up to very significant difficulties responding to the end of the Soviet Union, with the need to convert from military to civilian production, to adjust to higher energy prices, to create a market system for international trade, to create a market-based financing system to avoid financial catastrophe. None of that was really done.

What resulted were sharp declines in production in many existing sectors without compensating by developing new sectors. And there was financial chaos, most evident in the very high - some of the highest in the world - levels of inflation that occurred. Another problem has been the growing illegality and black market activity in the economy, since the state in the midst of all this chaos either chose not to, or could not, use the instruments of normal law.

Kaufmann: If we try to grade Ukraine's economic performance between one and 10, 10 being the best, there would be no disagreement that up to late 1994 it was a one or two. From late 1994 and early 1995 it gets about an eight, but then there is a hiatus later in 1995 - when "reform fatigue" and political factors against reform became organized and slowed it down.

More recently, the reform trend line appears to be in the right direction. But determined reform steps are needed during the remainder of 1996 to reap the fruits of actions taken so far. This is crucial, because the relation between policy reform effort and economic recovery is not linear. If you don't achieve a critical mass in terms of comprehensiveness and speed of reform, you get only the pain of reform implementation without a proportional amount of gain. This critical mass has not been achieved yet in Ukraine. But it is within reach and if the leadership fully grasps it this year, by 1997 you can start seeing positive socio-economic results.

There is a historical window of opportunity to accelerate market reforms. Reforms don't have to be perfect - nobody says it has to be zero inflation and 100 percent privatization, but the country has to meet the challenge and cross that threshold of further liberalization and privatization of economic activity - while maintaining fiscal stability.

Q: Did Ukraine start out as an "exploited" country?

A: Sachs: The idea of the exploitation of Ukraine by the USSR poses the wrong question. Exploitation, of course, is a core concept of Marxist economics. The essence of it is that life is a zero sum game - if you're doing badly, it must be because someone is taking from you. A lot of inquiry was invested in whether Ukraine was selling its goods more cheaply or less cheaply to Russia or whether Russian cheap energy compensated for the prices Ukraine was getting. All of that was insignificant compared to the fact that the situation was a disaster for Ukraine and for Russia and for everyone else.

The system of socialist economics was a misery. It led to a destruction of economic values as much as social and human values. Ukraine's experience in the Soviet Union was a disaster for Ukraine and independence beforehand would have been vastly better. The promise now is much greater because Ukraine has the chance for a completely different kind of economic organization - one based on freedom.

Pivovarsky: Politically, Ukraine was very much a colonial state. Ukraine did not have its own government, its own police, its own borders, even some cultural institutions. Now it is a post-colonial state that needs to reshape its identity through its government, its currency, its institutions. Economically, all of the countries suffered from mismanagement. Ukraine had to deal with this huge military industrial complex even in the 1970s - the system was created by the central government in a way that made it impossible for anyone to change it.

Kaufmann: It is useful to have a political and institutional perspective to understand why in the first few years after independence there were delays in Ukraine's economic reform and its transformation to a market economy. However, we should not give the impression that because of this perspective Ukraine is expected to have a much tougher prospect for economic recovery if the right reform measures continue to be implemented. We have seen other countries under similar circumstances that have gotten their act together earlier than Ukraine, with positive results. There are a number of examples from Central and Eastern Europe and even in the former Soviet Union.

The concept that Ukraine is so unique that you have to implement gradual or different reforms has been debunked completely. Every Soviet citizen had a similar burden when the transition started.

Q: How does Ukraine need to reform?

A: Sachs: There are four different aspects of the reform process. First, you must create an environment of stabilization: ending high inflation, having the state live within its means, creating enough order in the economy for other good things to happen. Ukraine started with a government with huge expenditure targets and few means to pay for them. It printed a lot of money - the result was very high inflation. The first task was getting that under control.

The second task was creating a new economic system that shifted from central planning to the market. This involves three processes. First, ending government intrusion into every aspect of economic life, i.e., "liberalization." That's actually easy, because at the very top you can just stop doing what you've been doing. A small team can liberalize a whole economy.

Next is building new institutions that are compatible with the market economy - a legal code to define and enforce property rights, contracts, etc. That's much harder. Then comes privatization. You have to define property rights, otherwise everything gets stolen.

Structural adjustment is the third broad agenda item; it is a bit of a euphemism - it means that some people must lose their jobs because their jobs don't make any sense in the economy and room must be made for new jobs and activities that respond to human needs. Ukraine was going to have to go through that painful process no matter what, because it had been built up as a military state.

Fourth is creating the conditions for sustained growth in the future - making a market economy that has a tax system, financial system, an incentive structure, international trade relations, an education system, etc.

Kaufmann: I can exemplify this at the ground level with two examples: electricity and agriculture. Electricity had a group of progressive, far-sighted individuals at the top, who decided early on that it needed to be transformed. Now it is fully corporatized and competitive at the electricity generation level. Very soon it should be one of the three most advanced electric systems in the world - comparable to the U.K. and Chile, and much more advanced than the other Europeans. They're coming to Ukraine to learn how it's done. That is in sharp contrast to agriculture, where you did not have that leadership and had many vested interests from the past, which opposed liberalization of marketing and privatization of agro-industries and land.

Q: On the social realm of reform:

A: Sachs: The post-Communist countries that tried to reform gradually "because of the pain" ended up much worse, whereas those that plowed ahead got through the difficulties and ended up in much better condition in social outcomes along with GNP growth. In Poland, life expectancy has continued to rise during this period, while still declining in Ukraine and Russia. Strong reform allows new sectors of the economy to begin to develop, supplying jobs, income and purchasing power. With gradual reform you don't get growth in the new sectors and you can't stop the decline of old heavy industry - no one wants the output - so you get pain and no growth.

Part of any working economy is a legal order - the Soviet system was not a legal order, but a kind of organized mafia of ruthless extent. When it ended there were at least two possibilities. One was to create a new legal order, based on constitutionalism and democratic rule; the other was to go from an organized mafia to a disorganized set of mafias. Unfortunately, in Ukraine and Russia the latter happened to an extent in the first years. If the state itself operates illegally or can't enforce law, then all other reforms cannot apply.

The good news is that Ukraine now has a Constitution and a fragile, but working, democracy as an important step toward creating a rule-of-law state.

Q: What can world institutions and governments do for the reform process?

A: Kaufmann: Think of reform and economic restructuring during the transition as climbing up a ladder. It is a difficult ladder to climb and it takes years. If the reforms are comprehensive and radical, then a number of things are done early on and quickly, while other (institutional) steps come afterwards, since they take time. First and foremost, the leaders in the country have to make the decision to start climbing the ladder and to be prepared to start taking bold steps.

Once the readiness is there, the international organizations should be ready to match every step up the ladder. A partnership-type situation, with substantial technical and financial support, commensurate with the steps taken by the leadership. Without that leadership and commitment to climb that reform ladder there is little that international organizations can do except for transferring human capital - patiently providing market-based skills, economic education and technical assistance, building a consensus and an understanding of what implementation and expected results of reforms are about.

Sachs: There is one other thing that the world ought to do for Ukraine: keep its markets open for Ukrainian exports. Unfortunately this is not the case in Western Europe right now. Ukraine has two kinds of products that it could export in much larger amounts. One is steel (given the build-up of excess capacity in the Soviet era), and the second is agricultural products. Both areas right now are blocked by the European Community.

This is a serious miscalculation by the West. It makes reform harder and the European Union ought to reconsider its policies in these areas. It does not make reform impossible, and Ukraine still has no choice but to plow ahead as fast as possible. But the European Union could definitely ease this process by having a more open trade policy with Ukraine.

One thing I've seen as an advisor to many countries is that if your domestic reform policies are to the point and ambitious, it gives you much stronger footing to demand reciprocal help from abroad. Thus, Ukraine's standing vis-à-vis Europe is weakened by the lack of discipline in Ukraine's own reform process over these five years. The more coherent, stronger and bolder Ukraine's own reforms are, the stronger the voice it is going to have vis-à-vis the European Union to push those markets open.

Q: What is Ukraine's economic future?

A: Sachs: Ukraine seems poised for growth under the right policies. If reform continues in an organized way, then we could say that Ukraine has probably reached the bottom of the structural adjustment process and the inevitable collapse of the old industry has probably reached its limit. You could conceive 7 or 8 percent growth a year, starting in the next couple of years, foreign investors taking a much bigger interest in Ukraine and big gains in trade with Western Europe as a major source of growth.

However, everything is fragile. Inflation is down, but only in the last few months. The budget deficit remains high - pressure for renewed inflation remains very real. Spending is not under proper control, not only because of social and political demands, but because the organization of government is inadequate. If Ukraine falls backward, it could get stuck in high inflation, widespread corruption, a lack of growth. How long could this go on? The bad news is it can go on an awful long time. Argentina was a case like that.

When we look at Ukraine we see a crossroads and a country that has, for the first time in centuries, its fate in its own hands. A great deal is going to depend on the choices that are being made right now. The adoption of the new Constitution is hugely important, and if it can now be followed and become a base for a rule-of-law state, that can be a focal point for economic reforms and then the future could look brighter and brighter. No miracles, but a steady increase in living standards from this point on.